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Suresh Krishnamurthy

IT IS just more than a year since Citicorp and ChrysCapital acquired large stakes, of more than 15 per cent each, in IVRCL Infrastructure. Citicorp does not hold a stake now and ChrysCapital, too, has started selling its stake in IVRCL.

That the holding period for their investments was only one year may be disconcerting. For institutional investors, the holding period of most stocks is significantly less than a year.

Active churning of portfolio, involving buying and selling stocks every month if not every day, is the norm. Irresponsible as this strategy may sound, the stock market seems to quite encourage it.

The rewards are significantly higher for fund managers who churn their portfolio. In addition, benchmarking of portfolio performance to indices also encourages portfolio turnover.

In practise, long-term investing has always meant staying invested in the market rather than in a stock. In today's market, it takes courage and skill to hold on to stocks for a longer time. It is also considered more risky.

Reward for churn

Most people are brought up on the investment theory that staying invested for the long-term is the only way to make money.

Empirical studies also have indicated that higher turnover leads to higher costs and lower performance. Folklore built around legendary investors such as Ben Graham, Warren Buffet and Peter Lynch also highlight the rewards of remaining wedded to the right stock.

Most institutional investors, however, pay only lip service to these tenets. Though they also look down upon extensive churning of portfolio, they do favour frequent tactical changes in asset allocation.

A holding period of three-to-six months for stocks is not considered irrational. The market, too, rewards such investors.

The performance of diversified equity funds is itself a testimony to the benefits of low holding periods.

Consider this. If you had invested in the top 150 stocks on the BSE (in terms of market cap) at the end of December 2000 and held on for four years without making any changes to the portfolio, you would have earned returns of 7.0 per cent per annum.

If, however, the proportion were changed (to account for changes in the market cap) every year, the returns would have risen to 23.7 per cent. If the proportion were changed every three months, the returns would have been 23.4 per cent.

Clearly, there is no penalty for active churn. If you also throw in the benefits flowing in from stock selection and `inspired' trading by knowledgeable fund managers, returns would have been higher still. No surprise that fund managers should be enthusiastic about the idea of portfolio churn.

Benchmarking demands

Benchmarking to market captalisation-weighted indices also demands that the fund manager turns over the portfolio aggressively.

An index is a portfolio of stocks. The allocation to each stock in an index portfolio changes every day. Allocation to stocks that gain in value increases while that to stocks that lose value decreases. It is a momentum game. In India, index portfolio, too, is changed practically every quarter feeding the need for turnover.

This index portfolio, where allocation changes every day, turned in returns of 19 per cent between 2000 and 2004 — substantially better than a buy-in-2000-and-hold-till-2004 strategy. Fund managers, benchmarked to indices such as Nifty, Nifty Junior or BSE 200 have no choice but to respond to this dynamic market allocation mechanism, as they cannot let their portfolio be totally out of sync. A portfolio that is totally out of sync is considered riskier by investors.

There is, thus, no option but to change the portfolio more frequently within a year. Such are the demands of modern portfolio management. In most parts of the world, taxes are low and do not dissuade active churn.

In India, too, taxes on short-term gains are significantly low at the portfolio level for the FIIs and non-existent for mutual funds.

For their part, investors will not complain as long as the returns are attractive.

Still, at least for the sake of choice, it would be better if an actively managed fund that abjures from needless portfolio turnover were available. The demands on the skill of the fund manager and the risk would be greater. Rewards, too, may be exciting.

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